Options: an incentive to cheat?

2007

CEOs and senior executives who are paid mainly in stock options are far more likely to misrepresent their company's financial position to rig its share price, new research has found.

Jared Harris, from the Darden Graduate School of Business Administration, University of Virginia and Philip Bromiley, from the Merage School of Business, University of California, argue that executives who stand to benefit directly from a rise in their companies stock price have a stronger incentive to cook the books.

"Stock options offer a strong incentive to raise the stock price above the strike price; indeed, the stock price must rise above the strike price for executives to profit from their options," the researchers said.

"This incentive motivates some executives to misrepresent financial outcomes to raise the stock price,"

The study, which appears in the current issue of the journal Organization Science, found that the two factors which substantially increase the likelihood of financial misrepresentation are extremely low performance relative to average performance in the firm's industry, and high percentages of CEO compensation in stock options.

"Millions and sometimes tens of millions of dollars worth of CEO compensation ride on these stock options," explained Prof. Bromiley. "That's enough to motivate some executives to deliberately fudge the books so that stock prices go up."

The study also determined that approximately one in 10 of the financial restatements examined by the authors was linked to fraud and illegal practices. Over five years, there was a nine percent likelihood that a company would misrepresent its finances and get found out.

But as the researchers point out, much malpractice and fraud doesn't get found out, meaning that the real level of misrepresentation is almost certainly higher than this.

In contrast, however, the authors found that bonuses had little influence on misrepresentation because options offer massively greater financial returns to CEO's than bonuses do.

"Unlike with stock options, we found no significant influence of bonuses on financial misrepresentation," they said.

In addition to firms with high levels of stock options, firms with massive losses relative to their assets also tended to misrepresent their financials.

The authors examined financial restatements prompted by accounting irregularities identified by the U.S. Government Accountability Office (GAO). The GAO identified 919 such restatements announced between January 1997 and June 2002. According to the GAO, these particular restatements resulted from "aggressive accounting practices, misuse of facts, oversight or misinterpretation of accounting rules, and fraud."